As investors, we always want our investments to generate a healthy return. However, investors often forget that returns stem from two, not one, extremely important factors:

  1. the business' ability to generate profits, and
  2. the price you pay for one share of those profits.

This idea of price versus returns provides the bedrock for the school of investing known as value investing. In this series, I'll examine a specific business from both a quality and pricing standpoint. Hopefully, in doing so, we can get a better sense of its potential as an investment right now.

Where should we start to find value?
As we all know, the quality of businesses vary widely. A company that has the ability to grow its bottom line faster (or much faster) than the market, especially with any consistency, gives its owner greater value than a stagnant or declining business (duh!). However, many investors also fail to understand that any business becomes a buy at a low enough price. Figuring out this price-to-value equation drives all intelligent investment research.

In order to do so today, I selected several metrics that will evaluate returns, profitability, growth and leverage. These make for some of the most important aspects to consider when researching a potential investment.

  • Return on equity divides net income by shareholder's equity, highlighting the return a company generates for its equity base.
  • The EBIT (short for Earnings Before Interest and Taxes) margin provides a rough measurement of the percent of cash a company keeps from its operations. . I prefer using EBIT to other measurements because it focuses more exclusively on the performance of a company's core business. Stripping out interest and taxes makes these figures less susceptible to dubious accounting distortions.
  • The EBIT growth rate demonstrates whether a company can expand its business.
  • Finally, the debt-to-equity ratio reveals how much leverage a company employs to fund its operations. Some companies have a track record of wisely managing high debt levels, generally speaking though, the lower the better for this figure. I chose to use five-year averages to help smooth away one-year irregularities that can easily distort regular business results.  

Keeping that in mind, let's take a look at ConocoPhillips (NYSE: COP) and some of its closest peers.

Company

Return on Equity (5-year avg.)

EBIT Margin (5-year avg.)

EBIT Growth (5-year avg.)

Total Debt / Equity

ConocoPhillips

7.82%

10.46%

7.78%

39.77%

Chevron (NYSE: CVX)

22.40%

12.55%

15.78%

10.44%

Marathon Oil (NYSE: MRO)

18.32%

9.25%

8.06%

33.77%

ExxonMobil (NYSE: XOM)

29.57%

14.58%

4.26%

10.08%

Source: Capital IQ, a Standard & Poor's company.

Conoco looks surprisingly meager on both a relative and absolute scale. Its ROE, growth, and margin figures all rank in the bottom half of the peer group presented here. Chevron looks like a significantly stronger candidate. It has above-average returns, margins, and growth. Similar to Conoco, Marathon looks mediocre. Its single digit margins and growth prospects look unappetizing. Exxon dominates this peer group on both the return and margin fronts, while lacking in growth. Additionally, all these companies have conservative financing. Also keep in mind that these companies enjoy somewhat of a tailwind. Surging commodity prices could potentially helps these firms in the years to come.

How cheap does ConocoPhillips look?
To look at pricing, I chose to look at two important multiples, price to earnings and enterprise value to free cash flow. Similar to a P/E ratio, Enterprise Value (essentially debt, preferred stock, and equity holders combined minus cash) to unlevered free cash flow conveys how expensive the entire company is versus the cash it can generate. This gives investors another measurement of cheapness when analyzing a stock. For both metrics, the lower the multiple, the better.

Let's check this performance against the price we'll need to pay to get our hands on some of the company's stock.

Company

Enterprise Value / FCF

P / LTM Diluted EPS Before Extra Items

ConocoPhillips

22.53

8.59

Chevron

14.95

9.87

Marathon Oil

12.17

11.53

ExxonMobil

16.81

11.43

Source: Capital IQ, a Standard & Poor's company.

With oil prices surging lately, these companies have gone on a tear. However, some of these companies still have reasonable enough valuations to the point that they become potential buys. Not necessarily a negative, Conoco's high EV/FCF multiple resulted from the highest capex in the group. On the flip side, they have the lowest P/E ratio among the group. Chevron looks attractively priced, as does Marathon with the lowest combined set of multiples among the group. Exxon, the strongest performer, still looks quite reasonable as well.

I think more than anything, buying one of these companies mostly depends on your view of the future, not the past. These companies look pretty cheaply priced for the most part. If you think oil still has room to run, these companies should all benefit from such an event. However as the Fed winds down its quantitative easing programs and interest rates normalize, the current tailwinds could fade slightly. Investor beware.

While ConocoPhillips looks like a possible stock for your portfolio right now, the search doesn't end here. In order to really get to know a company, you need to keep digging. If any of the companies mentioned here today piques your interest, further examining a company's quality of earnings, management track record, or analyst estimates all make for great ways to further your search. You can also stop by The Motley Fool's CAPS page where our users come to share their ideas and chat about their favorite stocks, or add them to My Watchlist.

Andrew Tonner holds no position in any of the companies mentioned in this article. Motley Fool newsletter services have recommended Chevron. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.